What is 'forward guidance'?

A man walks past the window of a shop selling clothing and goods bearing the Union Flag in London on August 7, 2013.

The Bank of England joined the global “forward guidance” club on Wednesday after the central bank said it would consider raising its short-term interest rate when the unemployment rate fell to 7 percent or below.

The term “forward guidance” has received a lot of attention in the media of late and it is worth explaining what it means and why it’s important.

Forward guidance is a promise about future monetary policy actions. The central bank is saying: “If this happens, we will consider doing this.”

It’s designed to give households, businesses and investors a clearer steer on when the cost of borrowing money might go up and avoid them sitting at home worrying about it. It thus enables them to better plan investments.

It is also aimed at turning low short-term interest rates into lower long-term interest rates for mortgage borrowers and businesses.

The Bank of England, like other central banks, controls the short-term interest rate, which is the rate at which it lends to and borrows from Main Street banks overnight.

If British Main Street banks know they will be able to borrow money from the Bank of England at the current record low of 0.5 percent for months, possibly years, to come, they may be more inclined to lend money at equally low rates to the general public.

And that’s good for the economy because it spurs investment.

Carney introduced forward guidance when he was governor of the Bank of Canada, and the strategy is also used by the U.S. Federal Reserve and European Central Bank.

The Bank of England’s forward guidance, however, is heavily conditional and left many investors unconvinced that interest rates would stay put for the next three years.

Carney said forward guidance could be abandoned if inflation expectations got out of control or record-low borrowing costs posed a threat to the country’s financial stability.

That's prompted some investors to raise their bets for interest rates to go up, which is not what the central bank intended.

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